Are airline stocks finally investable?

By
Michael Friedman

May 9, 2014

Airline stocks have long been tagged by investors as one of the most uninvestable groups in the stock market. As a business, airlines are capital-intensive, labor-intensive, and fuel-intensive on the cost side, while facing commodity pricing on the revenue side. Barriers to entry are astonishingly low, as any individual with a few billion dollars can start an airline (and several have), while barriers to exit are surprisingly high — not exactly a model for success.

If a capitalist had been present at Kittyhawk back in the early 1900s, he should have shot Orville Wright.

Yet after a nearly four-decades-long period of turmoil, labor strife, competition, and, ultimately consolidation, today's airline industry looks healthier than ever, making it a solid investment candidate once again, in our opinion. So what makes today's environment potentially different from the many failures of the past? We outline several reasons below:

From bankruptcy to financial health: How today's airline industry swung to a profit

A radical change in the airline industry

The Airline Deregulation Act of 1978, while a boon for passengers, signaled a radical change in airline economics. Prior to 1978, interstate domestic airline traffic was regulated by the Civil Aeronautics Board (CAB), a bureaucracy that set pricing, schedules, and lanes. Thus, carriers had little control over frequencies or what they could charge, but received some degree of protection on their lanes. In other words, the airlines could be assured a certain level of profitability in the good times and would likely face losses when traffic declined. But lack of competition meant that pricing was stable.

Everything changed after 1978. With the airlines free to schedule and price as they chose, they moved from a point-to-point, price-protected system to a hub-and-spoke, competitive one. The hub-and-spoke system is a mixed blessing for airlines. It offers the ability to connect passengers more easily and thereby widen an airline's network, but it is also highly inefficient, as planes sit for longer periods of time, waiting for passengers.

Over the next three decades, airlines discovered that they were facing a worst-case scenario. True, airlines were able to enact monopolistic pricing in their hubs, but the majority of passengers were on connecting flights, and now passengers had several hubs over which they could connect. Since most passengers are price-elastic, fares fell to the point where they simply covered marginal costs. To this day, in fact, on an inflation adjusted basis, fares are lower than they were prior to deregulation (source: Wolfe Research, as of April 2014).

And while fares started to decline, costs moved in the opposite direction. Pattern bargaining became the norm, as work groups would look at the most recently signed contract at a competitor and generally demand 1-2% more than that level. Knowing that the unions' strike funds could last longer than an airline generating no cash, management generally conceded. Once labor recognized that "mutually assured destruction" was working in its favor, its demands increased. Work rules became looser while hourly pay continued to move up. No management team wanted to lead the next Braniff or Eastern Airlines. In the good times, airlines were flying enough passengers to be profitable, but when the economy turned down, their income statements were devastated, as were their stocks.

With wages largely fixed, airlines had no choice but to raise prices. Leisure passengers, however, were highly price-elastic; a small change in pricing led to a significant decline in the volume of passengers. Business travelers, however, were just the opposite. Their tickets were often purchased last minute and, with most hubs existing in major cities, they often had only one or two options to travel. Thus, last-minute pricing went up and was often 6-7 times the fare that would have been paid only a month earlier. Airlines implemented rules such as Saturday night stays to differentiate between business and leisure passengers further.

The major carriers might have been able to survive with their business plan intact had it not been for the low-cost carriers, Southwest Airlines in particular. Unlike the major airlines, which ran inefficient, high-cost hub networks, Southwest was largely a point-to-point carrier that was never subject to regulation, since it originally flew only intrastate. Competition from Braniff forced Southwest to become low-cost early and it maintained this culture. It had one class of service and kept fares low, attracting leisure passengers and small businesses. Its work rules were more favorable to the company and management, led by the charismatic Herb Kelleher, generally had a good relationship with labor.

Instead of competing with the majors in their hubs, Southwest chose secondary cities near the hub. For instance, it would fly into Love Field in Dallas instead of Fort Worth, or Providence, R.I., instead of Boston. While Southwest may have been a gnat in 1971, it was the largest domestic carrier in the United States (in terms of seat-miles flown) by the mid-2000s. The majors became terrified of "the Southwest Effect," which was the decline in prices that took effect when Southwest came into its markets.

A race to the bottom: The United–US Airways merger that wasn't

By this time, it was becoming clear that the only way for airlines to generate enough revenue to survive was to gain massive market share. The problem with market share, however, is that it is easy to gain and easier to lose. As soon as your competitors under-price you, they pick up your share. Ultimately, it becomes a race to the bottom in which nobody wins. But there is one other way to pick up share from your competitors: You consider buying them.

Mergers, however, are difficult to pull off in the best of times and next to impossible in the worst. And for the airlines, they were about to enter the worst. The wheels came off the planes, so to speak, in 2000, when United Airlines made a bid for US Airways. And while the government and consumer groups were opposed to the merger, the biggest detractors were the employees, particularly the United pilots. So management did what it always does in this situation: It bought off the pilots, promising them that they would not lose any seniority. (A pilot's pay and what they fly are determined by seniority.) Or, if they did, they would receive the pay that they would have received had the merger not gone through. United hoped that the combined entity would generate enough revenue to offset the extravagant (some would say ridiculous) contracts.

As the economy turned south in 2001, however, and the Justice Department continued to oppose the merger, United saw the writing on the wall, paid US Airways a break-up fee, and walked away. But there was one problem: United had already promised its employees large wage hikes. Pilots received 25% hikes, with smaller wage hikes for the rest of the employees. Overall, United enacted a destructive 13% increase in its personnel line and failed to generate any additional revenue. And because of pattern bargaining, every other airline eventually had to match. United filed bankruptcy in 2002. In fact, virtually every major airline filed bankruptcy at least once in the decade, with US Airways pulling off the trick twice, once before, and once after, its merger with America West. A combined Delta-Northwest combination made it to 2005 before filing.

Bankruptcy begins to pay off

Bankruptcy proved to be somewhat of a panacea to the airlines, at least in terms of labor costs. Contracts were broken, pensions were frozen, and staffs were downsized. While not quite lean and mean, its costs were more competitive and the airlines were making money by the middle of the decade. Stocks rallied, particularly after US Airways made a bid for Delta in 2006, one that ultimately failed but would have cut capacity (and raised prices) significantly on the east coast. But that merger attempt proved to be the peak.

As the economy tumbled into the "Great Recession," airlines felt the pressure and their stocks tumbled, as well. US Airways, for example, which had peaked above $60 in 2007, fell to almost $2 per share by 2009. American Airlines was hit even worse, falling from more than $60 per share to $2, and eventually filing bankruptcy a few years later. Once again, airline investors learned the hard way that these stocks were simply trading stocks. (Data: Bloomberg.)

But something different happened this time: the airlines survived. With lower costs and lawyers in charge instead of traditional airline guys, the airlines took the focus off of market share and cut excess capacity, instead. Meanwhile, Southwest, which had survived the mid-decade fuel price shock with a series of strategic hedges, lost control of its other costs and saw its gap with the majors narrow. Continental and United merged in 2010, followed a few years later by US Airways and American. And as we enter 2014, the airlines look healthier than they have ever been, in our view.

Airlines have finally gotten their arms around their cost structures. Airlines have finally discovered what the American Airlines CEO, Doug Parker, seemed to discover years ago: He who has the lowest costs wins. Since airlines are forced to compete on price; they have to rely on low costs to make a profit. And low costs are not simply a function of payroll. For example, Southwest Airlines had the highest hourly rate for its pilots for years, yet maintained the lowest cost per seat mile flown (source: Wolfe Research). How did it pull off that nifty trick? By enacting work rules that paid pilots only when they flew, instead of the traditional legacy carrier method of paying pilots for a guaranteed minimum number of hours no matter how many they flew. As bankruptcies mounted and contracts were abrogated, labor lost much of its bargaining power. Eliminating in-flight meals is nothing compared to slight work-rule changes.

Airlines learned a new trick: Ancillary fees. Fees began as a way to offset internal costs, such as by charging to talk to an agent over the phone rather than booking online. But management teams eventually realized that these fees provided a way to raise revenues without actually raising ticket prices. Baggage fees, change fees, etc. have all become part of "unbundling" the product. Want a premium seat? That will cost you. Need to check a bag? There's another fee.

These fees also are very high-margin, with some of them, including baggage and change fees, closing in on 80% incremental margin. In other words, airlines that would have otherwise been only marginally profitable on a stand-alone basis have become wildly so because of the ancillaries. It is estimated that American Airlines will generate $2 billion from baggage and change fees alone, which would be more than $1.5 billion of operating profit. Those two fees alone could represent 1/3 of the company's operating profits in 2014. (Data: Wolfe Research.)

Consolidation changed the playing field. Historically, there were too many players chasing market share within the airline industry. But that changed in the post-consolidation era. Before the recession of 2008-2009, the top four airlines represented 58% of all domestic seat miles. Only seven years later, the top four own 86% of those seat miles, and that number is rising. To put that figure in perspective, it would take 31 airlines in the European Union to generate that same 86% market share. (Source: Wolfe Research, Bureau of Labor Statistics.)

Fortunately, decades of bankruptcies may have finally paid off. Instead of fighting for market share, airline CEOs have realized that they control enough of the market that they simply don't need to gain incremental and minimally profitable, share. Instead, they are focused on industry strength in addition to that of their own carrier. Meanwhile, labor has been pacified with either equity or profit sharing. A decade ago, managements never would have discussed return on invested capital (ROIC) because they couldn't count on consistent returns. Now, ROIC and shareholder returns are top of the list. Two of the four large airlines pay dividends, and at least one of the remaining two is actively discussing it.

Investor implications

If airline managements continue to deliver on their promises, we believe investors could add 2-3 points of multiple expansion to the group, a bit below what the rails saw when they finally started to concentrate on returns. While airlines do have more upside potential on the earnings front, they are not as volatile as the rails, nor do they dominate individual markets with zero threat of competitive entry (that is, a rail company cannot simply pick up and move a train if a competitor's market is doing better).

Nevertheless, airlines are beginning to generate cash flow and return it to shareholders, first in the form of balance sheet repair, and later, with dividends and share repurchases. This means that the airlines shouldn't backslide when the economy turns down, but these managements have seen what happens in bankruptcy and aren't anxious to return to it. Furthermore, they own equity in their companies, as well. Personal enrichment, in addition to shareholder enrichment, is never viewed as a bad thing.

From our perspective as bottom-up (stock-by-stock) investors, we believe that a successful company will succeed on the strength of its management, the competitiveness of its productive asset base, the quality of its balance sheet, and the structure of its global market positioning. In general, sector or industry weighting is less important to us than the quality of the underlying companies we own. That said, we currently own two airline stocks within the global portfolio that share similar characteristics of focus on shareholder returns, cost savings, rising revenues through ancillary fees, robust market share, and strong management teams.

The views expressed represent the Manager's assessment of the market environment as of May 2014, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.

Carefully consider the Funds' investment objectives, risk factors, charges, and expenses before investing. This and other information can be found in the Funds' prospectuses and their summary prospectuses, which may be obtained by visiting our fund literature page or calling 800 362-7500. Investors should read the prospectuses and the summary prospectuses carefully before investing.

IMPORTANT RISK CONSIDERATIONS

Investing involves risk, including the possible loss of principal.

Diversification may not protect against market risk.

Past performance does not guarantee future results.

International investments entail risks not ordinarily associated with U.S. investments including fluctuation in currency values, differences in accounting principles, or economic or political instability in other nations. Investing in emerging markets can be riskier than investing in established foreign markets due to increased volatility and lower trading volume.

More from Michael Friedman

Michael Friedman biography

Michael Friedman, CFA

Vice President, Senior Equity Analyst

Michael Friedman is a senior analyst for the firm’s Global and International Value Equity team. Prior to joining Delaware Investments in April 2011, he worked with The Boston Company Asset Management as a senior analyst, initially focusing on consumer, transportation, and auto stocks for the core research group, and later overseeing the consumer and autos sectors and portions of the industrial sector for the Large Cap Global team. Previously, he was a senior equity analyst at American Express Financial Advisors, where he followed consumer stocks, and he completed an internship with Wells Fargo Bank, analyzing trends in internet consumer banking. Friedman earned his bachelor’s degree, cum laude, from the University of Pennsylvania, and an MBA from the University of Chicago Graduate School of Business.

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